People have a lot of concerns about retirement. In fact, a quick Google search for “retirement concerns” came back with 82.8 million results. These concerns include things like when to retire, how to spend your time in retirement, and a host of others.
But although there are a lot of retirement concerns, if you look at retirement articles from major publications like Money Magazine, CBS News, or The Motley Fool you’ll see that retirees have 2 major concerns:
- The availability of affordable health care
- Outliving their retirement savings
The general advice for addressing the concern about running out of money is always the same – work longer, save more money, and reduce your spending. And while that’s all helpful advice, I suspect that just about everybody reading this website has already done those things.
Today I’m going to talk about a powerful tool that few people know much about – the deferred annuity.
Retirement planning requires guessing
The problem with retirement planning is that it depends entirely on making guesses about the future. And the further into the future you look, the less accurate those guesses will be.
For example – I feel pretty confident that I can tell you what interest rates will be tomorrow, next week, or next month. The error bars on my guesses would be a big higher when making projections about interest rates next year. And I would have absolutely no idea what interest rates will be like in 10 years or 30 years.
Similarly, pretty much everybody plans for retirement using these steps:
- Figure out how much money you have already saved
- Figure out how much money you can save each year
- Make a guess about what future returns will be
- Decide at what age you’d like to retire
- Calculate how much money you’ll have at your projected retirement date
- Use the “4% rule” or some variation of it to calculate how much money you’ll be able to spend in retirement.
- Adjust steps 2, 3, or 4 until you get a number in step 6 that you like
The problem is that steps 3 and 6 are total guesses. It’s impossible to know-what future investment returns will be. And while it’s reasonable to assume that long-term future returns will be pretty close to long-term past returns, there’s no way of knowing what the return will be for any given 10-year or 20-year future time period.
This is critically important, because the average retirement is approximately 20 years. According to the US Social Security Actuarial Table, at 65 years old the average man can expect to live 17.8 more years and the average woman can expect to live 20.36 more years. These are, of course, averages, meaning that roughly half the people live longer than the average and half the people don’t.
Deciding how to make retirement savings last 20+ years can be tricky. Many people rely on the 4% rule to manage withdrawals. The 4% rule says that every year you can withdraw 4% of your initial nest egg at retirement, adjust annual for inflation, and you won’t run out of money for at least 30 years.
Related: The death of the 4% rule
On the face of it, this sounds like great news. 30 years is almost twice as long as a 65-year old man can expect to live. The problem of course, is this – what if you live longer or retire sooner than the average?
You can obviously control WHEN you retire, but you (unfortunately) have a lot less control over how long you live.
In retirement it’s much better to fail early than fail late
This gets us to the underlying problem – you won’t know that your retirement withdrawal plan is failing until it’s too late to do anything about it.
It’s pretty easy to make a course correction if you retire early at 45 years old and then at 55 you realize that perhaps you won’t have as much money as you thought you would. At 55 years old you can go back to work. Your skills might be a bit stale but are largely still relevant. You still know people in your industry. You are physically able to work 8 hours a day. You can get another job and get back on track financially.
Things are very different if you’re 75 when you realize that your retirement plan is failing. If you retired at 45 that means your skills are 30 years out of date. Your industry contacts will likely all be retired. You’ll face rampant age discrimination. You’ll likely have medical problems that will prevent you from working many (if not most) jobs.
Of course, very few of us will retire at 45 years old. But what if you retire at 65, rely on the 4% rule, and live longer than your life expectancy?
THIS is the nightmare scenario in retirement. You retire, interest rates drop, the stock market is flat (or down) for a decade, and your retirement savings are irreversibly drained. You realize that your savings aren’t going to last, but there’s nothing you can do about it (other than cut your standard of living to something painfully low).
And the longer the expected retirement the more uncertainty there is about what kind of returns you’ll earn.
Thankfully, there’s a solution to this problem – annuities.
What is a deferred annuity?
Annuities come in an almost limitless number of variations, but for the purposes of this discussion let’s break them down into 2 categories:
- Immediate annuities
- Deferred annuities
An immediate annuity is pretty self explanatory. You purchase an immediate annuity and “immediately” (which usually means within a month or so) start receiving a monthly income for the rest of your life.
With a deferred annuity you purchase the annuity now and then start receiving a monthly income at some point in the future. That point in the future could be next year, in 5 years, in 10 years, or some other timeframe.
With both types of annuities there’s nothing
Annuities have no value once you die. If you buy an immediate annuity and die in 2 months your money is still gone. Similarly, if you buy a deferred annuity that starts paying in 10 years, but you die in 8 years, you receive nothing.
This last point is key. The fact that you could purchase an annuity and receive nothing is a big part of what scares people away from annuities. But here’s the thing:
Annuities are not investments.
Annuities are insurance policies.
Once you understand that, the value of annuities will become more clear. Just like with any other insurance policy, annuities help in managing risk.
You have a homeowner’s insurance policy to protect against the financial risk of your house burning down. You have car insurance to protect against the financial risk of getting into a car accident. You use an annuity to protect against the risk of running out of money.
The value in a deferred annuity is that the eventual payout can be quite a bit higher than with an immediate annuity. This is for 2 reasons. First, the payment is in the future, which means the insurance company can take the money you pay now and invest it to make more money. Second, there’s the chance you’ll die before you start collecting any benefits. This means they can pay higher benefits to the people who do survive to the start of the annuity.
How much higher is the potential payout for a deferred annuity? Well, a 65-year-old couple could purchase a $100,000 immediate annuity today and receive just under $6,000/year for life. If the same couple instead purchased a $100,000 20-year deferred annuity (first payments would start at age 85), the subsequent payments would be nearly $32,000/year for life instead!
The good news of this approach is that the payments in the later years are dramatically larger with a longevity annuity than an immediate annuity. The bad news, of course, is that you have to wait 20 years to get the first check!
How long does it take until the total amount paid by the deferred annuity exceeds the total amount paid by the deferred annuity? I thought you’d never ask.
Using the fact pattern above (a 65-year old couple can purchase an immediate annuity paying $6,000/year or a 20-year deferred annuity that pays $32,000/year) we see that once the deferred annuity starts paying at age 85, the total payout passes the total immediate annuity payout after just 4 years.
So, in this case, if the couple were to both die before age 89, they were better off with the immediate annuity. At 89 or later, the deferred annuity has a higher total payout.
Retirement planning would be a lot easier if you knew exactly when you’ll die
As I mentioned before, the biggest problem with retirement planning is that we have no idea how long we are going to live, which means we have no idea how long our money needs to last.
Retirement planning would sure be a lot easier if you knew that you were going to die at, say, 85 years old, wouldn’t it?
Look at the chart below. This is a table of the findings from the study that the “4% rule” was developed from.
The thing that most people got from this table is that if you have a portfolio that’s somewhere between 0%-75% stocks (and 100% – 25% bonds), you’ll have a 100% chance of having your money last for 30 years.
But here’s what I see – if we can guarantee that this money only needs to last for, say, 20 years, we can take a MUCH higher percentage of the portfolio and still have a 100% chance that the money will last.
Looking at the chart, I see that if we want our money to have a 100% chance of lasting 20 years then we can allocate our portfolio to 25% stocks and 75% bonds and withdraw a massive 7% per year.
If you were willing to take on a bit of risk (say we wanted a 85%+ chance of our money lasting for 20 years) then we see that we could pull out 8%/year if our portfolio was anywhere from 50%-75% stocks and 25%-50% bonds.
Of course, this is all wishful thinking. Nobody knows exactly how long they are going to live, which means we have no idea how long our money needs to last…right?
Guaranteeing how long your money needs to last
But wait…we CAN guarantee how long our money needs to last if we use a deferred annuity! If you buy a deferred annuity that starts paying in 20 years then your retirement savings only need to last for 20 years.
You now know exactly how long your money needs to last!
Here’s how it would work. At age 65 you have $1M in retirement savings. You use $300,000 to buy a 20-year deferred annuity. This will pay $96,000/year starting at age 85. You now need to make the remaining $700k of your nest egg last for 20 years (until the deferred annuity kicks in). Based on the table above we know that we can safely withdraw 7% of our initial lump sum of $700,000 and have a 100% chance of it lasting for 20 years.
Here’s what your income would look like using this method vs. the standard 4% withdrawal rule:
The blue numbers show the result of initially taking 7% of your $700,000 savings (the other $300k was used to buy the deferred annuity) and then annually adjusting 3% for inflation. This lasts until you turn 85, at which point your deferred annuity kicks in. Note that you actually get a nice increase in your yearly spending at age 85 (from $85,992 at age 84 to the annuity payment of $96,000 at 85).
The green numbers show the result of initially taking 4% of your $1M savings and then annually adjusting for 3% inflation. This is the “4% rule” withdrawal plan.
I’ve run the numbers through age 95. You’ll note that for every year from age 65 to age 94 you’d have MORE money using the 7% withdrawal/deferred annuity strategy than you would using the standard 4% withdrawal method. This is because the numbers I found for the deferred annuity were for a fixed annuity (it’s not adjusted annually for inflation). An inflation-adjusted annuity would have a lower initial payout but it would grow with inflation.
Another thing to remember is that you’d continue receiving your annuity payments for as long as you live. The 4% rule only guarantees that your money will last 30 years. What happens if you’re one of those people who lives to be 100? Or 115?
The deferred annuity guarantees that you never outlive your money.
Conclusion
You can take the information above and tweak it to work for different retirement scenarios. Maybe you want to retire at 50 years old. You could purchase a deferred annuity that starts paying at 70, then plan on spending your existing savings over the next 20 years. Or you could retire even earlier (at 45) and buy a deferred annuity that starts paying at 75, and plan on making your money last from 45 to 75 by picking up odd jobs here and there.
In this case, by using a deferred annuity to protect against outliving your money, you can both reduce the overall risk to your retirement as well as ensure high annual spending than you’d otherwise have.
A lot of people are wary of annuities, and for good reason. Annuities are often saddled with high fees and low returns. Some annuities are terrible products.
But that doesn’t mean all annuities are poor products. Annuities can be a powerful planning tool if they are used the right way.